Behavioral Economics

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Certain Decisions

One of the books I keep close by on the shelf is Paul Glimcher’s “Decisions, Uncertainty, and the Brain: The Science of Neuroeconomics”.  It dates back to 2004 and is one of those books that provides a glimpse of what a dialog between economic theory and psychology might produce.  More to the point it explores the issues surrounding economic decision making at a deep biological level.  It thus adds substantially to the behavioral explanation of economic activity.

Apart from making me think about the practical problems of decision making, one of the additional benefits I had from reading the book was that it introduced me to David Marr whose work was instrumental in the development of neuroscience. a few decades back.

Here’s a very long quote taken from Marr’s book “Vision” and I hope you can see its relevance to the plight of contemporary economics:

” Almost never can a complex system of any kind be understood as a simple extrapolation from the properties of its elementary components.  Consider, for example, some gas in a bottle.  A description of thermodynamic effects — temperature, pressure, density, and the relationship among these factors — is not formulated by using a large set of equations, one for each of the particles involved.  Such effects are described at their own level, that of an enormous collection of particles; the effort is to show that in principle the microscopic and the macroscopic descriptions are consistent with one another.  If one hopes to achieve a full understanding of a system as complicated as a nervous system, a developing embryo, a set of metabolic pathways, a bottle of gas, or even a large computer program, then one must be prepared to contemplate different kinds of explanation at different levels of description that are linked, at least in principle, into a cohesive whole even if linking the levels in complete detail is impractical.  For the specific case of a system that solves an information-processing problem there are in addition the twin strands of process and representation, and both these ideas need some discussion.”

One of the great failings in mainstream economics is its futile insistence that all theory must stand on the shoulders of what are called “micro foundations”.  Such an insistence is a clear denial of the complexity of a modern economy and that within such complexity phenomena worthy of study can emerge at different levels of detail.  Of course there is the additional issue that economists of this ilk also deny that the faux-psychology upon which they construct those micro-foundations is naively simple and hopelessly inadequate.  Yes, behavioral economics is beginning to change that, but the damage being done every day by the adherence to rational expectations based micro is too awful to contemplate.  Marr is clear that the macro and micro descriptions ought to be consistent, but that one follows necessarily from the other is not the same thing.  Need the micro must be consistent with the macro.  So descriptions developed at a more aggregate level ought inform our thinking lower down.

Not everything can be reduced to the decisions of individuals as if the interactions between individuals doesn’t produce phenomena of interest also.  Glimcher, of course, is writing his book at the level of the individual, and looking at the brain as a complex system, but Marr reminds us that emergence is something we need to deal with as we scale upwards through larger and larger aggregations of activity.

Mainstream economics has, by and large, obstinately refused to embrace such an approach.  By so doing it has denied itself the ability  to interpret or explain some aspects of the macro economy,  and has isolated itself from the kind of fresh thinking that might have helped it avoid the calamity of its failure prior to the 2008 crisis.

Until the entire concept of rationality is re-worked to adhere to real world experience and behavior, and until the consequences of complexity are fully brought on board, modern economics will continue to flail and will continue to decline in relevance.  So it will leave open the opportunity for other disciplines to offer more relevant and coherent explanations of economic activity — if they haven’t done so already.

 

Addendum:

For fans of the intersection between neuroscience and economics here is another quote I dug up from another Glimcher book.  On one of its early pages, as he describes the arc of progress in recent years, he remarks on a special conference issue of the journal of the Society for Neuroscience.  The editors, he says, write in their introduction:

” Within neuroscience, for example, we are awash with data that in many cases lack a coherent understanding … Conversely, in economics, it has become abundantly evident the pristine assumptions of the standard economic model — that individuals operate as optimal decision makers in maximizing utility — are in direct violation of even the most basic facts about human behavior.”

The gig’s up.

It is time to reinvent economics.

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Limits

I don’t understand why people get upset when I say that economics is a waste of time. I suppose it’s because I don’t make a clear enough difference between economics as a general topic and economics as a formal, mainstream, body of knowledge. It’s the latter that is a waste of time. The former is wonderfully interesting.

At its heart economics is a study of human behavior, where that behavior is specific to certain activities. It is thus deeply rooted in psychology, so it is more closely associated with biology than physics. This is not a new idea: some of the greatest economists of the past have argued as much. Trying to transfer in ideas from physics, even metaphorically, therefore tends to lead to dead ends.

Like the notion of efficiency. That’s something of great interest to engineers, but has little to do with economics. You can have an efficient physical system. You cannot have an efficient social system. There’s just too much we don’t know and can never know. Still economists all over the world are obsessed with efficiency. So what do they do? They start to abstract and simplify. They model and fine tune. They test and re-test. And still their ideas run afoul of reality: human beings are not efficiency seeking machines, and so any system filled with humans is likely to be darned near impossible to steer towards efficient outcomes. Nothing daunted economists press on. If humans are unlikely to be efficient the logical next step is to construct a theory to exclude actual humans. That’s what’s happened in economics: the faulty decision to root economics in a physics-like setting rather than in a biology like-setting forced subsequent generations of economists to “refine” their thinking and, eventually, to force real people out of their theoretical world. Voila! Modern economics ends up as a wonderful edifice with extravagant claims as to its ability to understand human behavior precisely by eliminating all contact with humanity. Weird.

Ergo, if your goal is to understand real economies replete with real humans, modern economics is a waste of time.

Go study something else. You can learn a great deal about real economies by reading psychology literature. Behavioral economics — which despite all the press it gets has had only a marginal impact on the mainstream and on textbook economics — is an attempt to do that. The behavioral economics project is in its infancy. Go get involved.

By the way: anything that refers to strategic behavior is also useful. Real humans are constantly trying to outwit each other. That’s when they’re not cooperating, which is another human characteristic economics determinedly overlooks.

Humans are complicated. Too complicated for an economics built on an exclusive belief in relentless rationality.

Furthermore, many psychologists are now challenging the entire premiss that humans are calculating machines in the manner of computers. Our ability to compute sits uneasily with a far more powerful and deeply rooted set of survival skills that are experiential and heuristic. We are not rational information processors. We cobble things together. We try things out. We are really good at pattern recognition. As calculators we, well, suck. Yet economics bases itself on the notion that we are computational wizards. There is nothing in modern psychology to support this idea, but it persists in economics. Indeed economics is proud of its ersatz psychology and exports its “insights” into other social sciences with imperial abandon. It ought not. Its insights are embarrassingly rotten.

Worse: so proud is economics of its [bad] understanding of human behavior that it insists all economic theorizing be based on it. Thus we have the insistence on building macro theory on micro-foundations. At the risk of upsetting thousands of dedicated and well-meaning economists: garbage-in garbage-out just about sums up the micro-founded enterprise.

There is in evolutionary biology, as I am sure you all know, a notion called a “fitness peak”. Roughly speaking, this is the idea that a species refines its survival strategy and succeeds in a certain context. As it does so it “climbs” higher up a successful strategic slope that defines it relative “fitness”. Problems arise when the context subsequently changes. The more superbly refined fitness becomes, there more difficult it is to go back down and climb a different and more relevant slope. Yesterday’s cleverness becomes todays’ ignorance. The advantage of the old peak becomes a hindrance in the newer landscape.

So it is with economics.

It began in the context of the mid and late-1800’s obsession with physics. It’s greatest critique is situated in mid-1800’s industrialization. Economics began its climb up its own fitness peak back then. But the context has changed. Science has moved on. Economics hasn’t kept up. Instead it keeps on refining its obsolescence. It keeps on getting more and more specialized at something that is less and less relevant.

It needs re-doing.

Which is what a lot of people are working on: socio-economics; behavioral economics; evolutionary economics; experimental economics; institutional economics and many other fields are veritable hives of activity, they just haven’t made it into the textbooks.

Meanwhile what we call mainstream economics is, indeed, a waste of time.

 

Addendum:

This article in Aeon is a good example of the kind of thinking we need to import into the new economics mainstream. 

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I Don’t Care About the You-Know-What Prize

Every year around this time many of you get seriously vexed over the award of something the we know as the sort-of-Nobel prize in economics. And every year I get swept up in the hubbub.

Not this year.

I have decided to ignore the entire thing. Who cares? I don’t. Nor should you.

Nor do I care any more whether economics is a science of not. Who cares? I don’t. Nor should you.

We have wasted a whole lot of time arguing, discussing, and otherwise pondering whether economics deserves its singular status within the social sciences. It doesn’t. So let’s move on.

Now I realize I am not giving you all a lot of evidence to support my case here. I ought, to be truly rigorous about this, to present a series of examples and reality checks upon which to base my case. But am not going to that. No. Not at all. I am simply going to assert that economics is basically libertarian ideology wrapped up in mathematics to disguise its lack of content and its right wing intent. It can’t hold a proverbial candle to sociology or psychology when it comes to explaining real people’s behavior. So there. I said it.

And I can do this proudly.

Why?

Because I learned a thing or two from economics!

Who needs evidence? Not when you can just assert stuff. People are rational. Economists say so. And if you complain about it, they just say that people behave as if they’re rational so that’s as good as being rational. So there. Take that psychology! All you need are incentives. Really. That’s it. You can motivate anyone by holding cash or starvation in front of them. Understanding humans is so easy. I don’t understand why we even need psychologists. Economists figured out how people behave decades ago. Did I mention they’re rational?

Really rational. Honest. Well not honest, because honesty is suspect. It isn’t incentive based enough. Always. Enough.

Oh. And markets fix absolutely everything. I mean that. And governments just muck things up.

I don’t mean to patronize you all, but anyone who thinks that programs to help the poor actually help anyone is being foolish. You need incentives. Lots of incentives. Like starvation. All this welfare stuff is just going to diminish efficiency. And efficiency is absolutely the only goal humans have ever had. Ever. Pareto said so. Well sort of. He denied it later, but that’s when he’d gone soft.

My hero Tom Sargent – he’s just one of my heroes – said it back in 2007:

 “Everyone responds to incentives, including people you want to help. That is why social safety nets don’t always end up working as intended.”

Now that’s patronizing grandeur I can admire. All you silly liberal people ought stop helping people and get a few more incentives out there. Like starvation. Or cash.

Anyway, back the sort-of-Nobel prize. Angus Deaton clearly deserves a big prize. He comes from Scotland, which had an enlightenment, and works in America where all the economists live. So we know he’s clever, and he needs a prize to keep up with his neighbors. All American economists get the Nobel prize. I think. It looks that way. If they live in Chicago. Or know where Chicago is. It’s in America. All economists know that.

Angus gets the prize because:

“Prof. Deaton unquestionably deserves a prize for his work to better understand consumption, poverty, and welfare in developing countries, particularly when economic inequality is under the microscope.”

To better understand consumption, poverty, and welfare …

It would be churlish to mention the split infinitive. So don’t. The key is that economists are giving themselves prizes for better understanding consumption, poverty, and welfare. These are things we need to know a lot more about. After all economists have been talking about them for the best part of two hundred and fifty years. So it would be good to better understand them. Just in case all that time they’ve been talking drivel. It helps to better understand the central topics of your subject.

Except for people. We don’t need to better understand them at all. Economists have them figured out completely.

No. Really.

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Time Warp Economics

One of my ongoing complaints about economics is that it seems hidebound and horribly out of date. It seems stuck in the steam age with its references to land, labor and capital. Its models conjure up images of the titans of industry forging new railways across open plains and building vast steel works or cotton mills in once pristine valleys. There are landlords preying on peasants, while workers labor away in Dickensian conditions. Words straight from those bygone years litter its lexicon. The very notion of the margin was born from the forced usage of the worst farmland as the population grew, and from the distances wagons had to travel to market towns in northern Germany.

Not that there’s anything wrong with this, as long as we add more modern stuff along the way.

And that’s the problem.

Even reading the 1950’s work on pricing is an adventure back into an archaic world. Nowhere, or at least not very prominent, are concepts drawn from all the advances of the last couple of decades. It may be useful to talk about production functions and cost plus prices, but they remind me of astrolabes while I live in an era of GPS devices.

Leafing through an average economics paper or book I am left imagining a world largely bereft of mega banks; international companies managed by large self serving bureaucracies; internet sales; digital transmissions; or computer use. Very little seems to be made of the vastly more rapid flow of information, or that many of our products nowadays are entirely information based. It’s as if we never left the industrial era.

This may not matter. But I suspect it does. I suspect that a finer breakdown of labor would reveal very different influences on wage patterns and inequality. Models that treat labor as one big glob probably miss this detail. The same goes for capital.

It may well be that the basic 1800’s categories are sufficient to explain a 21st century economy. But I would like to be sure.

We are often told that capitalism adapts. If so, why are we looking at it through the same old lens? Land, labor, capital. Is that it?

It seems to me that the economy moves from one state to another. Each state being the result of some vastly complex computation based upon a massive set of variables. The space of those states is thus practically infinite. Yet the movement of the economy from one state to another is heavily constrained. We made it thus. We set boundaries by establishing institutions and cultural norms. Its movement is constrained by geography and the resource limits that are associated with location. Our ability to exploit those resources hinges on our knowledge and technology. The networks through which we communicate limit the flow of knowledge and capital. Society with its classes and other fractures gets in the way of smooth operation. And, of course, each configuration of the economy limits the possibilities for the next. Then we must account for the feedback between our current activity and each of these constraints.

It is tempting, in that face of this complexity, to simplify. We build models to explore pieces that interest us. Sometimes we dare to encompass the entire economy in one such simplification, and impute properties like equilibrium to tame the beast sufficiently for our imaginations to explore. We imagine that properties at one level of granularity flow untouched onto other levels either above or below. We remain faithful to the foundations of the discipline.

But if we don’t update our thinking, if we ignore progress, we run the risk of becoming anachronistic. Our models look quaint next to the reality they are supposed to explicate. We are condemned to add ever more sophisticated spheres to our Ptolemeic systems in order to keep up with emerging knowledge. We scramble for ever more ludicrous assumptions, and when all else fails we simply assert axiomatically that the world is the way we need it to be for our steam driven models to remain in touch with the electronic age. It is flat if we only have the tools to examine flat worlds.

One example: it is odd that it took such an effort to insert technology into our models as a driver of growth. In our zeal to cut the problem down to manageable size we eliminated most everything resembling an actual economy, and ended up focusing on allocation or heavily constrained optimization. That is pointless, because we are no longer examining anything that exists. Anyone familiar with complexity, self-organization and evolution is comfortable with systems that mutate, adapt and change from within. Technology is an obvious component of such change. It is entirely ordinary to consider it. Not extraordinary.

The mechanistic, individualistic, reductionist time warp that orthodox economics is trapped in does a disservice to our future. It is inappropriate. It is inaccurate. It is dated. So is the reliance on the same set of alternatives. Kalecki, Keynes, Sraffa, Robinson, the entire lot need to be freshened up. With them we moved from a goods based analysis to one inclusive of credit, money and finance. Now we need to embrace information. We need to move on and not keep arguing over the same time worn issues that occupied our forbears.

Here’s an idea: the information content of the economy has exploded. The products we make now are information intense. The algorithm needed to explain those products is more complicated and lengthy than that needed to explain the average product made seventy years ago. Our thinking about what an economy is needs to keep up.

And that goes for all you DSGE fans too.

Then again I may be wildly wrong. After all an astrolabe would still help you navigate the world. Sort of.

But I know it’s not flat.

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Astrological Economics: Just What is Bernanke’s Sign?

For a subject as dry and mathematically inclined as economics, at least in its orthodox version, the linkage between the real world an the merely imaginary is more tenuous than most laypeople would think.

This occurred to me today when I read an excellent letter in the Financial Times. In it an MIT lecturer talks about how limited the average person’s grasp of rational choice is. We are mostly quite irrational even though we often try to be very sensible in our decision making.

“Star charts are as useful in predicting asset price bubbles as orthodox theory. Why? Because at least an astrologer doesn’t doubt their existence.”

This is, of course, not news to any of us. That’s why many of us find it quite difficult to make decisions about even trivial aspects of life.

The so-called ‘Paradox of Choice’ is a good example. [See Barry Schwartz’s book] Economists theorize that giving consumers a myriad choices will, inevitably, produce the best result: the more choice, the more likely that a consumer will find something that exactly matches what they want.

But this flies in the face of our evolutionary roots. We are not cognitively equipped to get into finely grained decision making, where we are required to evaluate nuanced differences. We are it bit brutish in our thinking. We are equipped for simple and often binary decision making: the kind of on-the-fly type of thinking that primitive animals have to make in order to survive to live another day. So when confronted by a plethora of choices most of us simply freeze up and avoid making any choice at all.

A practical example of this is the supermarket. Researchers have shown that someone going to the supermarket with a specific purchase in mind – say toothpaste – will often turn around and leave if there are too many varieties, flavors and brands on the shelf. It is better, in other words, for the shelf to sport a quite limited choice. Sales will be higher and consumers happier.

Contrast this real world research finding with the assumption within free market economic theory that consumers are ‘perfectly rational’, and we can start to comprehend why economics is such a mess. It is more astrology than science.

The entire edifice of free market theory rests on the notion that you and I are supreme calculators. That we are not defeated by shelf loads of products, but that we are capable of feats of analysis, consciously or not, that allow us to arrive at extraordinarily precise decisions that inevitably lead us to maximize our welfare. We never make mistakes. Never.

Sound familiar?

No, I didn’t think so.

I realize it seems very dull, but I want to reiterate the importance of of this small example: our economic lives have been run for years by people who’s outlook on life is conditioned by, and depends upon, on exactly the theory derived from assumptions like that of ‘perfect rationality’.

Take away perfect rationality, and the superiority of markets, as opposed to, say, governments, as allocators of scarce resources crumbles. That means no one can ‘prove’ that markets left to their own devices will always outperform the government.

So the debate reverts to a political one.

Which is why it is urgent that economics recovers itself from the dead end it was driven into seventy years ago and abandons most of the thinking accumulated since then. It simply isn’t true. Worse: it leads to severely handicapped public policy making. It allows ideologues like Reagan and Bush to slam the government – which is their right from an ideological perspective – from within an aura of scientific discipline.

There are times when markets are terrible – sub-prime mortgages anyone?

Bubbles are common structure within capitalist economies. So are business firms. But both bubbles and firms cannot exist within the purity of orthodox economics. Perfection has no room for the messiness of either.

The Nobel prize winner Ronald Coase pointed out to his economics colleagues in 1937 that since business firms seem to be quite common the profession ought to re-consider its allegiance to perfection. Instead he was ignored for decades and only much later did a subculture sprang up inside the profession studying firms. But the textbooks remain pristine. Indeed the firm as an economic entity remains a curiosity and is ignored by most academics.

So too with bubbles. Visit most academic economist websites and you will find all sorts of opinions as to why bubbles cannot be predicted. Many will deny they exist – even now. This is because they are all so inculcated with the perfectionist view that they fail to see the real world. And rather than admit their subject has a big hole in it, they attempt to explain away the Emperor’s nakedness by resorting to all sorts of arcane and highly jargon laden reasoning.

Economists have even begun to argue that their inability to reject a negative argument against their own theory is sufficient to justify its continued existence. Think about that: they take the fact that they have nothing to say as support for a theory. This is hardly Popperian refutation. It is vacuous.

The fact remains that economists are faced with a choice: either their subject is failing to explain many very common economic structures; or it is akin to astrology.

There are hopeful signs: people like Robert Thaler, mentioned in the letter I referenced at the beginning of this post, are slowly chipping away at the outmoded and mechanistic thinking that supports the orthodox theory. But they have a very long way to go.

Meanwhile ideologues still latch onto the orthodox theory in order to justify their politically motivated views. Which affects all of us. The current debate about health care reform would be so much more sensible were it rooted in real world claims about the efficacy of markets rather than being supported by an orthodoxy that resembles the reading of star charts.

So too would the re-regulation of banking.

The relevance of economic theory has never been greater. That’s why it is fun to get involved in the debate. In large part, the crisis we are living through is a creation of orthodox theory. Which is why it’s protagonists are so vocal in their attempts to misdirect our attention: Robert Lucas, Martin Feldstein, Robert Barro, John Taylor, and many others are constantly popping up in the media to pull the wool over our eyes. Their common theme is that it is the government’s fault. Or, failing that, they throw their hands up and claim that no one, absolutely no one, could possibly have seen the crisis arising.

They protest too much.

Their economics is beautiful. Intricate. Intense. Intellectually fascinating. Difficult to master. Brilliantly conceived. And about as scientific as astrology.

Star charts are as useful in predicting asset price bubbles as orthodox theory. Why? Because at least an astrologer doesn’t doubt their existence.

So with respect to the discussion over whether Bernanke should be re-appointed as Fed chairman: only if he was born under a propitious sign. Turns out he’s either Sagittarius or Capricorn. It is quite obvious that the Fed has far too many of those already. Time for one of us more solid, some would say dull, Taureans?